US: Taxation of copyright sales: ordinary income or capital gain?

Tax day presents several interesting questions for copyright holders, not the least of which is how the Internal Revenue Service (IRS) will treat income from the sale or exclusive license of a copyright. If a copyright is a "capital asset," proceeds from its sale or exclusive license are a capital gain rather than ordinary income, and the transaction will be taxed at a much lower rate.

Prior to 1950, whether a copyright was a capital asset was largely determined by the professional status of the author. A copyright was not a "capital asset" if could be described as "inventory" of that profession, or "property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business." So, for example, in Fields v. Commissioner, the Second Circuit held that, where the taxpayer was a professional playwright, sale of the film rights to a play was a transaction "in the ordinary course" of this profession, and thus should be treated as ordinary income.

But there was confusion around the edges. For example, in Estate of Chandor v. Commissioner, painter Douglas Chandor had volunteered to create a portrait of Franklin Roosevelt, Joseph Stalin and Winston Churchill at the Yalta Conference, but Stalin scuttled the plan by refusing to sit. This left Chandor with a draft "study" of Churchill, which he sold in 1948 to financier Bernard Baruch for $25,000. The IRS argued that, because Chandor was a professional painter, the proceeds from the sale of any of his paintings should be treated as ordinary income. But the United States Tax Court disagreed. Although Chandor was a professional portrait painter, he had previously painted only specifically commissioned works, and had never before created a painting and then held it for sale. Moreover, the painting was only a study, and "usually these studies are never disposed of until after the death of the artist." Therefore, it was improper to treat the painting as if it were ordinary "inventory" held for sale to customers, and the income from its sale was a capital gain.

In 1950, Congress sought to diminish uncertainty in this area of the law by passing what is now codified at Section 1221(a)(3) of the Internal Revenue Code. That section provides that "capital assets do not include a copyright held by a taxpayer whose personal efforts created such property." In other words, individual artists like Chandor could no longer treat as a capital gain the income from the sale of the rights in their own work, regardless of the context. So, for example, in Stern v. United States, a Louisiana federal court held that, "unfortunately for the taxpayer," the sale of the "Francis the Talking Mule" franchise by its author, shortly after this new law went into effect, had to be treated as "ordinary income." In 2005, Congress amended Section 1221 to allow copyrights in musical works to be treated as capital assets, but other types of creative work are still subject to Section 1221(a)(3).

Notably, the IRS has indicated that the reference in Section 1221(a)(3) to "personal efforts" may limit its application to individuals, thus excluding corporations. However, in Revenue Ruling 1962-141, the IRS ruled that the sale of television broadcast rights by corporations, because it had become a common practice in the entertainment industry by that time (1962), should be treated as if it were inventory sold "in the ordinary course" of that business, and thus any profit from the sale of such rights was ordinary income. As a practical matter, this suggests that, even if a copyright holder is a corporation or an individual not subject to the "personal efforts" language, the IRS is still likely to view proceeds from the transfer of these properties as ordinary income, provided that such transfers regularly occur within the relevant industry. Businesses and individuals with questions about the appropriate tax treatment of copyright transfers should consult a specialist.

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